Unfair but balanced commentary on tax and budget policy, contemporary U.S. politics and culture, and whatever else happens to come up

Friday, December 30, 2011

New York Times article on corporate stock options

In today's Times, David Kocieniewski has an article noting how the revival of stock prices has led to a new explosion of executive stock options offering huge payouts to high-ranking executives. The article emphasizes the entity-level tax angle, which is that, when the executives exercise their options - typically at a huge profit, even if their companies have failed to outperform the stock market - the companies get huge deductions that may zero out their taxable income.

The natural reply to make to this critique is that there is no tax angle after all, if the executive is taxed at the same marginal rate as the company. (And note that even a company facing a low average rate on its income, due to other tax planning such as causing its U.S. income from intangibles to be treated as arising in tax havens, may face a 35% marginal rate in the effective range.) Thus, if Steve Ballmer gets a $100 million stock option and both he and Microsoft face 35% marginal rates, then its $35 million tax saving is offset by his $35 million tax bill. Denying it the deduction but taxing the underlying income only once - by allowing him to receive it tax-free - would lead to an identical after-tax result on both sides of the transaction if it responded to the change in rule by paying him $65 million.

I doubt many readers of this blog entry will consider this either a novel or a hugely surprising point. Indeed, it is made repeatedly, and at times vituperatively, by readers of the NY Times article who posted comments discussing it. So let em just add two further lines of discussion here.

First, I would certainly agree that the executive comp discussed in the article is a huge problem, even if it isn't a tax problem. The issues it raises are twofold: distributional and corporate governance. As to the former, rising executive comp over the last 20 years is a huge contributor (both directly and indirectly) to rising U.S. income inequality during this period. Conventional economic theory would suggest that this merely reflects that the execs are adding more value, so even if you dislike the distributional result it would be gratuitously inefficient to attack rising executive comp as such. I happen to think that conventional economic theory is wrong in this case, but that would require a lengthy discussion of its own that doesn't really fit well here.

So let's move on to corporate governance. A large part of the appeal of stock options to inside players as an executive comp tool lies in the opportunity that the options offer to facilitate looting of publicly traded companies, if you want to put it as rudely and crudely as possible. Or. if you want to put it more politely, stock options are a really crucial tool for overpaying mediocre executives - not all of whom can be above-average, after all. Even without any tax angle at all, the options offer a wonderful excuse to compensate the mediocre as if they were geniuses, by allowing them to ride the overall rise in the stock market to claim huge payouts that they pretend reflect their own influence on the stock price. (And if the stock market goes down rather than up, no problem - the company simply reprices the options and gives the executives another chance. So it is rather like getting to place huge bets on the roulette wheel where it's someone else's money, and where if red doesn't come up this time you get to try again and again.)

While this is a serious corporate governance problem, to a degree one could argue that the tax system actually helps, rather than making things worse. High-ranking executives might be happier still if stock options were nondeductible, assuming that this meant that they would also be treated as tax-free to the grantee. Returning to the Ballmer-Microsoft example, in such a state of the world they could announce the value of the grant (at exercise) as only $65 million, yet it would produce the same end result as giving him $100 million under current law.

Indeed, taxpayers like this result so much that they are often apparently quite willing to risk paying MORE tax overall if this permits them to steer as close to it as present law permits. As a starting point for explaining this, note that options could in principle be taxed earlier still - when they are granted, rather than when they are subsequently exercised via a purchase of the company's stock at the option's strike price.

Why aren't executive stock options taxable when granted? After all, they may have significant option value even if they are not yet "in the money." The reason that they usually are not taxable when granted is that they usually remain subject to a "substantial risk of forfeiture" (rather than having irrevocably vested), rationalized on the ground that they represent contingent compensation for future services that might affect the stock price and thus the option value.

Under the relevant Code provision, however, employees can elect to have the options valued and included (as well as deducted by the company) in the year when they are granted. If they make this election, the option is valued as if the risk of forfeiture did not exist.

This in turn led for years to the following tax planning trick. I elect to have my option valued and included / deducted in the year when it's granted. But I claim that the option value is zero, reflecting that it is not yet in the money (i.e., the stock price doesn't yet exceed the exercise price). In fact, the claimed value is ludicrous, since the person claiming the zero value would very likely refuse to sell the option, if this were permissible, even if offered many thousands (or perhaps millions) of dollars for it.

The IRS was so upset about this trick that it issued a regulation providing that, if the option's value isn't sufficiently "ascertainable" (which basically requires that it have an observable market price), taxpayers can't go the election route here. So the IRS effectively forces many taxpayers, contrary to their preferences and an arguably fairer reading of the statute itself before the regulation was issued, to wait for taxable income at a later point.

The funny thing about this, in turn, is that, once the employee has recognized taxable income (and the employer a matching deduction), further appreciation is taxable to the employee (though generally at just the capital gain rate) without a matching employer deduction off any kind. So the low valuation "scam" that taxpayers prefer and the IRS prevents may actually be a route to higher, rather than lower, overall taxation.

What could possibly be going on here? Well, probably several things. For one, if the company has net losses (as may be common in the start-up period even without tax haven games and the like) then the employer deduction doesn't actually make up in full for the employee inclusion. For another, if you hold the stock until death then the deferred tax on post-taxability appreciation permanently disappears. Perhaps a few people are myopic and just want to defer the employee-side day of reckoning. Executives who are trying to hide the ball regarding how much they are actually getting paid don't want to pay tax sooner since it's inconvenient to have to rely on gross-up to make themselves whole.

Bottom line, without condemning today's article in the Times there are still some interesting angles to pursue, though it's possible that the editors would consider them too esoteric for a page 1 placement. But perhaps still worthy of page 1 in the business section?

About Me

I am the Wayne Perry Professor of Taxation at New York University Law School. My research mainly emphasizes tax policy, government transfers, budgetary measures, social insurance, and entitlements reform. My most recent books are (1) Decoding the U.S. Corporate Tax (2009) and (2) Taxes, Spending, and the U.S. Government's March Toward Bankruptcy (2006). My other books include Do Deficits Matter? (1997), When Rules Change: An Economic and Political Analysis of Transition Relief and Retroactivity (2000), Making Sense of Social Security Reform (2000), Who Should Pay for Medicare? (2004), Taxes, Spending, and the U.S. Government's March Towards Bankruptcy (2006), Decoding the U.S. Corporate Tax (2009), and Fixing the U.S. International Tax Rules (forthcoming). I am also the author of a novel, Getting It. I am married with two children (boys aged 24 and 21) as well as three cats. For my wife Pat's quilting blog, see Patwig’s Blog.